Market selloff emphasises that this cycle isn’t finished

September 2022

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The news overnight, Tuesday 14 September, Australia-time, of a sharp Wall Street sell-off, was a stinging reminder that the equity and bond market correction cycle, which began towards the end of last year, still has a way to go.

This inconvenient truth was masked by the July/August ‘head fake’ when markets staged a bear market rally causing some to think the worst was over and normal service was returning.

But as we said in our June commentary, on the heels of the financial market dive that month, markets tend to bottom and then begin to recover after dramatic events – such as the October 1987 crash, the 1994 bond market sell-off, the bursting of the tech bubble in 2000, the 2008/09 GFC, and the March 2020 COVID-crash – when central bank (and government) policies become more sympathetic.

As things currently stand, central banks would be condemned if they changed direction to support financial markets.

While annualised US inflation was a nosebleed 9.1% in June, the latest US Consumer Price Index reading of 8.3%, over the year to August,1 was both barely better in comparison, as well as being worse than expected.

Markets were especially spooked by the breadth of cost increases. Oil prices have cooled a little, but measures tracking rent, baby clothes, alcohol, car insurance, furniture, and medical costs rose 6.1% in August from a year ago, the biggest jump in 40 years.2

Moreover, inflation across the world’s wealthy countries, including Australia, is at levels not seen for decades. The Reserve Bank of Australia has forecast inflation here to reach around 7.75% by the end of 2022.3 You have to go back to the 1980s since we last experienced that level of inflation in Australia.

Aggressive central bank rate hikes are going to be needed to bring price pressures under control, and that most likely means choppy markets ahead.

US Federal Reserve has been clear about rate rises

We can’t say we haven’t been warned. Chairman of the US Federal Reserve, Jerome Powell, recently said,4 in part (we’ve highlighted key words):

“The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.

Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Higher interest rates, slower growth, and softer labour market conditions will bring down inflation, they will also bring some pain to households and businesses.”

The 2% inflation goal referenced by Mr Powell is similar to most industrialised country central banks’ inflation targets. Given the wide gap between that figure and inflation momentum, it’s inescapable that interest rates will be going higher, and investors are going to have to steel themselves for their impact.

Share and bond market implications: ‘something’s gotta give’

High inflation and rising interest rates are headwinds for shares as well as traditional bonds and erodes the complementary attributes the two asset classes generally provide portfolios.

Usually, bonds offer portfolio resilience when shares fall. However, when inflation is the driving force in markets, there is a positive correlation between the two, and as both fall, portfolios suffer.

As it is, despite large downward share market moves since late last year, share market valuations, as conveyed by price-earnings (P/E) ratios,5 remain high in the United States (see chart), and other developed world markets, particularly when compared against today’s high levels of inflation.

Chart 1: US share market valuation remains high despite high inflation

S&P 500 average price/earnings ratios and 12-months inflation levels

Chart 1: S&P 500 average price/earnings ratios and 12-months inflation levels

Through July 2022
Source: IBES via Datastream

Rising interest rates explain most of the downward share market price moves, and there has not yet been much of a downgrading of companies’ earnings expectations that you would typically see as economies enter downturns.

It’s as if markets have been pricing a Goldilocks scenario for the US economy where inflation comes down quickly and the US Federal Reserve somehow avoids inducing an earnings recession despite rate hikes.

A scan of US equity bear markets since the 1960s suggests that situations where share prices are down double digits, but P/E ratios are still quite elevated, amid high inflation, is unusual.

In other words, we’re in a ‘something’s gotta give’ situation if P/E ratios are to stay around their present above long-term levels (see chart).

Either company earnings are going to grow in the face of higher inflation, higher interest rates and the likelihood of a slowing economy, or share prices are going to have to fall further.

Time-tested investment principles steering clients’ portfolios

Most investment professionals have grown up in an era of low and falling interest rates, and so the present high inflation dynamic does present a new challenge. However, our investment team has already steered clients’ portfolios through other testing times, including the 2008/09 Global Financial Crisis and 2020’s COVID episode.

Furthermore, we believe that by sticking by time-tested investment principles, like diversification, we can steer portfolios through what lies ahead.

Times of market volatility also creates opportunities as stressed investors can feel compelled to sell quality assets at attractive prices. Our portfolios’ ample liquidity equips them to be able to participate in buying opportunities that may emerge.

Our investment team prepared for the inflationary upswing ahead of its full materialisation and that’s reflected in how we are managing and positioning the MySuper portfolios,6 as discussed below.

MLC MySuper portfolios’ positioning: role of unlisted assets

We have been mindful that the global economic outlook has dimmed since the start of the 2022 calendar year. On top of that, the troubling trio of rising inflation, higher interest rates, and the disruption to energy, industrial commodity, and agricultural markets, wrought by war in Ukraine has meant that the investment climate has becoming increasingly complex.

Consequently, we have persisted with an underweight position in share markets. We have also been utilising our experienced in-house derivatives team to implement strategies that cushion a portion of our share exposures against the full impact of market falls.

The MySuper portfolios also continue to benefit from the strong cashflows, and inflation-protection associated with what we term ‘mid-risk’ assets, such as unlisted infrastructure, and real estate.

These assets have different return patterns to shares and traditional fixed income investments and offer attractive returns that contrast with share market volatility.

Within the MySuper portfolios, infrastructure investments include Tilt Renewables, Australia’s largest renewable energy platform, and AusNet which owns Victoria’s regulated electricity transmission network.

The cashflows of essential services, such as electricity transmission, are often linked to regulatory regimes with inflation protection, which, of course, makes them so suited to times like now.

Our high quality property assets are spread across the office, retail, and industrial sectors. The industrial sector continues to ride the e-commerce trend, which has meant that warehousing and logistics centres have become sought-after assets.

Our private equity investments, that is, investments in companies not listed on share markets, continue to be important parts of the MySuper portfolios.

We and our managers can directly influence companies’ business strategy through private equity investments and by doing so drive operational and financial improvement. This has historically been a good source of return generation over and above that available in listed equity markets and we believe is likely to continue to be a source of value add into the future.

Accessing alternative credit

Traditional fixed income assets are increasingly unattractive propositions as inflation gains a grip. However, this doesn’t mean that investors should walk away from all forms of fixed income.

There are opportunities in the much harder to access world of alternative private credit, which can provide very attractive yields along with diversification benefits.

Investing in such credit opportunities can be rewarding particularly in situations where the collateral backing the lending are high quality assets and cash flows uncorrelated to the broader economy, for example, lending for legal receivables and government backed receivables.

In both cases, investors get paid well to take risk regarding when a payment is made, but with minimal risk as to whether it will be paid (hence making it a much better diversifier than mainstream credit investing). Most of the underlying yields associated with alternative private credit assets are set at a fixed premium above the cash rate, which means overall income payments rise with interest rates.

What all this adds up to is that the MySuper portfolios are well diversified across asset classes, within asset classes, as well as by manager styles and philosophies.

It means that they are not reliant on any single investment or type of investment to accumulate returns.

1 US inflation rise sees Wall Street make biggest loss in two years on fears of more large rate hikes. Sue Lannin, 14 September 2022, https://www.abc.net.au/news/2022-09-14/asx-to-follow-wall-st-down-on-us-inflation-figures/101436998

2 Why horror US inflation data panicked markets, Chanticleer column, September 14, 2022, https://www.afr.com/chanticleer/why-horror-us-inflation-data-panicked-markets-20220914-p5bhx4

3 Statement by Philip Lowe, Governor: Monetary Policy Decision, 2 August 2022, https://www.rba.gov.au/media-releases/2022/mr-22-21.html#:~:text=The%20Bank%27s%20central%20forecast%20is,3%20per%20cent%20over%202024.

4 Monetary policy and price stability, Chair Jerome H. Powell, At “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2022, https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm

5 The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s share price and earnings per share (EPS). It is a popular ratio that gives investors a better sense of the value of a company

6 See https://www.mlc.com.au/personal/superannuation/products/mysuper for more about MLC MySuper

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